Many studies of recent macroeconomic history document changes in the pace and pattern of macroeconomic activity that have occurred over the past two decades.47 Other studies suggest that a major reason for these changes is that the Federal Reserve System has altered its behavior in important ways. For example, Goodfriend (1993) argues that the U.S. monetary policy decision-making came of age—gaining important recognition and credibility—during this period, after having earlier traveled on a wide-ranging odyssey. Ac-cordingly, in this section, we explore how some key features of our previous analysis change if we restrict attention to 1986.7–2001.11. The start date of this period was selected as descriptive of recent U.S. monetary policy with increased credibility, following the narrative history of Goodfriend (2002): it includes the last few years of the Volcker period and the bulk of the Greenspan period. We focus our attention on two sets of issues. First, how did the esti-mated variability in the permanent component of interest rates change during this period? Second, how did the estimated importance of the expectations effects on the long-short spread change during this period?
The Stochastic Trend in Interest Rates
One important conclusion from our earlier analysis is that there is a common stochastic trend in interest rates, which is closely associated with the long rate. To conduct the analysis for the recent period, we start by reestimating the VECM discussed in Section 3 and reported in Table 4. Then, we calculate the permanent component suggested by this specification, producing the results reported in Figure 7 and Table 9.
We focus on two main results. First, as Figure 7 shows, the stochastic trend continues to be an important contributor to the behavior of both the long-term and short-long-term interest rates. As in the full sample period, it is closely associated with the long rate. Further, it is much less closely associated with the short rate.
47 For example, see Blanchard and Simon (2001) or Stock and Watson (2002).
Table 9 Summary Statistics for Two Decompositions
Subsample Estimates (1951.4–2001.11) A. Short-Rate Changes
Total Permanent Temporary
0.4409 −0.0003 0.4411
−0.0019 0.0476 −0.0478
0.9501 −0.3137 0.4890
B. Long-Rate Changes
Total Permanent Temporary
0.0636 0.0536 0.0100
0.9747 0.0476 0.0061
0.6314 0.4422 0.0039
C. Spread
Spread Expectations Term Premium
1.8917 1.4574 0.4343
0.9950 1.1341 0.3232
0.9475 0.9108 0.1111
Notes: Each panel contains a 3 by 3 matrix in a manner similar to Tables 5 and 8. On the diagonal, variances are reported. Above the diagonal, covariances are listed. Below the diagonal, the corresponding correlation is reported.
Panel B of Table 9 provides more detail. It shows that changes in the common stochastic trend (permanent component) have a variance of 0.048, which is less than one-half of the comparable variance reported in Table 5.
Thus, there is evidence that the stochastic trend is less important for both short-term and long-short-term interest rates. We can measure this reduced influence on our rule of thumb. Based on the full sample, we calculate that a 1 percent rise in the long rate should bring about a 97 percent rise in the predicted permanent component. On the recent sample, this rule-of-thumb coefficient is smaller:
a 1 percent rise should bring about only a 84 percent increase in the predicted permanent component.48 Yet, while the effect is smaller, changes in long rate still strongly signal changes in the stochastic trend.
48 In terms of elements of Table 9, the rule-of-thumb coefficient is calculated as b = 0.0536/0.0636= 0.84.
Figure 7 Interest Rates and Stochastic Trend, Once Again
Expectations and the Spread
Another important conclusion of our analysis above is that the spread is an indicator of forecastable temporary variation in short-term interest rates and, in particular, of market expectations of these variations. Figure 8 and panel C of Table 9 show that this relationship has been maintained and, indeed, has apparently gained strength during the recent period. In particular, if we look at rule of thumb #2 for the spread, which indicates the extent to which a high spread should be interpreted as reflecting a high expectations component, then the rule-of-thumb coefficient is 0.77= 1.46/1.89 for the recent period, whereas it was only 0.69 for the entire sample period.49
In sum, the two reported differences for this more recent period are in-triguing, and it is natural to think about possible sources of the change in
49 We think that a natural next stage of research involves a more systematic inquiry into the evolving nature of the links between short-term rates and long-term rates. For example, Watson (1999) argues that increased persistence in short-term interest rates—which in our case would involve evolving VAR coefficients—helps explain the increased variability of long-term rates from the 1965–1978 period to the 1985–1998 period. This section, by contrast, argues that the changes in the persistent component in interest rates (the stochastic trend) were less important during 1986–
Figure 8 Spread, Expectations, and Term Premia, Once Again
stochastic properties of the term structure. For example, we might conjecture that the reduced importance of the permanent component is the result of a more credible, inflation-stabilizing monetary policy. Given the lack of structure in our present analysis, however, it is impossible to support such a claim with statistical evidence or to quantify its importance compared to other potential explanations. Rather, we consider that these findings highlight a topic that warrants further investigation.